1Chapter Audit Planning and Analytical Procedures  Review Questions 8-1 There are three primary benefits from planning audits: it helps the auditor obtain sufficient appropriate evidence for the circumstances, helps keep audit costs reasonable, and helps avoid misunderstandings with the client 8-2 Eight major steps in planning audits are: Accept client and perform initial planning Understand the client’s business and industry Assess client business risk Perform preliminary analytical procedures Set materiality, and assess acceptable audit risk and inherent risk Understand internal control and assess control risk Gather information to assess fraud risks Develop overall audit plan and audit program 8-3 The new auditor (successor) is required by SAS 84 (AU 315) to communicate with the predecessor auditor This enables the successor to obtain information about the client so that he or she may evaluate whether to accept the engagement Permission must be obtained from the client before communication can be made because of the confidentiality requirement in the Code of Professional Conduct The predecessor is required to respond to the successor’s request for information; however, the response may be limited to stating that no information will be given The successor auditor should be wary if the predecessor is reluctant to provide information about the client 8-4 Prior to accepting a client, the auditor should investigate the client The auditor should evaluate the client’s standing in the business community, financial stability, and relations with its previous CPA firm The primary purpose of new client investigation is to ascertain the integrity of the client and the possibility of fraud The auditor should be especially concerned with the possibility of fraudulent financial reporting since it is difficult to uncover The auditor does not want to needlessly expose himself or herself to the possibility of a lawsuit for failure to detect such fraud 8-5 SAS 108 requires the auditor to document their understanding of the terms of the engagement with the client in an engagement letter The engagement letter should include the engagement’s objectives, the responsibilities of the auditor and management, and the engagement’s limitations An engagement letter is an agreement between the CPA firm and the client concerning the conduct of the audit and related services It should state what services will be provided, whether any restrictions will be imposed on the auditor’s work, deadlines for completing the audit, and assistance to be provided by client personnel The engagement letter may also include the auditor’s fees In addition, the engagement letter informs the client that the auditor cannot guarantee that all acts of fraud will be discovered 8-1 8.6 Because the Sarbanes-Oxley Act of 2002 explicitly shifts responsibility for hiring and firing of the auditor from management to the audit committee for public companies, the audit committee is viewed as “the client” in those engagements 8.7 All audit and non-audit services must be preapproved in advance by the audit committee for public companies 8.8 The second standard of fieldwork requires the auditor to obtain an understanding of the entity and its environment Auditors need an understanding of the client’s business and industry because the nature of the business and industry affect business risk and the risk of material misstatements in the financial statements Auditors use the knowledge of these risks to assess the risk of material misstatement and to determine the appropriate extent of further audit procedures The five major aspects of understanding the client’s business and industry, along with potential sources of information that auditors commonly use for each of the five areas are as follows: Industry and External Environment – Read industry trade publications, AICPA Industry Audit Guides, and regulatory requirements Business Operations and Processes – Tour the plant and offices, identify related parties, and inquire of management Management and Governance – Read the corporate charter and bylaws, read minutes of board of directors and stockholders, and inquire of management Client Objectives and Strategies – Inquire of management regarding their objectives for the reliability of financial reporting, effectiveness and efficiency of operations, and compliance with laws and regulations; read contracts and other legal documents, such as those for notes and bonds payable, stock options, and pension plans Measurement and Performance – Read financial statements, perform ratio analysis, and inquire of management about key performance indicators that management uses to measure progress toward its objectives 8-9 During the course of the plant tour the CPA will obtain a perspective of the client’s business, which will contribute to the auditor’s understanding of the entity and its environment Remember that an important aspect of the audit will be an effective analysis of the cost system Therefore, the auditor will observe the nature of the company’s products, the manufacturing facilities and processes, and the flow of materials so that the information obtained can later be related to the functions of the cost system 8-2 8-9 (continued) The nature of the company’s products and the manufacturing facilities and processes will reveal the features of the cost system that will require close audit attention For example, the audit of a company engaged in the custommanufacture of costly products such as yachts would require attention to the correct charging of material and labor to specific jobs, whereas the allocation of material and labor charges in the audit of a beverage-bottling plant would not be verified on the same basis The CPA will note the stages at which finished products emerge and where additional materials must be added He or she will also be alert for points at which scrap is generated or spoilage occurs The auditor may find it advisable, after viewing the operations, to refer to auditing literature for problems encountered and solved by other CPAs in similar audits The auditor’s observation of the manufacturing processes will reveal whether there is idle plant or machinery that may require disclosure in the financial statements Should the machinery appear to be old or poorly maintained, the CPA might expect to find heavy expenditures in the accounts for repairs and maintenance On the other hand, if the auditor determines that the company has recently installed new equipment or constructed a new building, he or she will expect to find these new assets on the books In studying the flow of materials, the auditor will be alert for possible problems that may arise in connection with the observation of the physical inventory, and he or she may make preliminary estimates of audit staff requirements In this regard, the auditor will notice the various storage areas and how the materials are stored The auditor may also keep in mind for further investigation any apparently obsolete inventory The auditor’s study of the flow of materials will disclose the points at which various documents such as material requisitions arise He or she will also meet some of the key manufacturing personnel who may give the auditor an insight into production problems and other matters such as excess or obsolete materials, and scrap and spoilage The auditor will be alert for the attitude of the manufacturing personnel toward internal controls The CPA may make some inquiries about the methods of production scheduling, timekeeping procedures and whether work standards are employed As a result of these observations, the internal documents that relate to the flow of materials will be more meaningful as accounting evidence The CPA’s tour of the plant will give him or her an understanding of the plant terminology that will enable the CPA to communicate fluently with the client’s personnel The measures taken by the client to safeguard assets, such as protection of inventory from fire or theft, will be an indication of the client’s attention to internal control measures The location of the receiving and shipping departments and the procedures in effect will bear upon the CPA’s evaluation of internal control The auditor’s overall impression of the client’s plant will suggest the accuracy and adequacy of the accounting records that will be audited 8-10 One type of information the auditor obtains in gaining knowledge about the clients’ industry is the nature of the client’s products, including the likelihood of their technological obsolescence and future salability This information is essential in helping the auditor evaluate whether the client’s inventory may be obsolete or have a market value lower than cost 8-3 8-11 A related party is defined in SAS 45 (AU 334) as an affiliated company, principal owner of the client company, or any other party with which the client deals where one of the parties can influence the management or operating policies of the other Material related party transactions must be disclosed in the financial statements by management Therefore, the auditor must identify related parties and make a reasonable effort to determine that all material related party transactions have been properly disclosed in the financial statements 8-12 Because of the lack of independence between the parties involved, the Sarbanes-Oxley Act prohibits related party transactions that involve personal loans to executives It is now unlawful for any public company to provide personal credit or loans to any director or executive officer of the company Banks or other financial institutions are permitted to make normal loans to their directors and officers using market rates, such as residential mortgages 8-13 In the audit of a client previously audited by a different CPA firm, it would be necessary to obtain a copy of the corporate charter and bylaws for the permanent files and to read these documents and prepare a summary abstract of items to test for compliance In an ongoing engagement, this work has been performed in the past and is unnecessary each year The auditor’s responsibility is to determine what changes have been made during the current year and to update and review the summary abstract prepared in previous years for compliance 8-14 The information in a mortgage that is likely to be relevant to the auditor includes the following: The parties to the agreement The effective date of the agreement The amounts included in the agreement The repayment schedule required by the agreement The definition and terms of default Prepayment options and penalties specified in the agreement Assets pledged or encumbered by the agreement Liquidity restrictions imposed by the agreement Purchase restrictions imposed by the agreement 10 Operating restrictions imposed by the agreement 11 Requirements for audit reports or other types of reports on compliance with the agreement 12 The interest rate specified in the agreement 13 Any other requirements, limitations, or agreements specified in the document 8-4 8-15 Information in the client’s minutes that is likely to be relevant to the auditor includes the following: Declaration of dividends Authorized compensation of officers Acceptance of contracts and agreements Authorization for the acquisition of property Approval of mergers Authorization of long-term loans Approval to pledge securities Authorization of individuals to sign checks Reports on the progress of operations It is important to read the minutes early in the engagement to identify items that need to be followed up on as a part of conducting the audit For instance, if a long-term loan is authorized in the minutes, the auditor will want to make certain that the loan is recorded as part of long-term liabilities 8-16 The three categories of client objectives are (1) reliability of financial reporting, (2) effectiveness and efficiency of operations, and (3) compliance with laws and regulations Each of these objectives affects the auditor’s assessment of inherent risk and evidence accumulation as follows: Reliability of financial reporting – If management sees the reliability of financial reporting as an important objective, and if the auditor can determine that the financial reporting system is accurate and reliable, then the auditor can often reduce inherent risk and planned evidence accumulation for material accounts In contrast, if management has little regard for the reliability of financial reporting, the auditor must increase inherent risk assessments and gather more evidence during the audit Effectiveness and efficiency of operations – This area is of primary concern to most clients Auditors need knowledge about the effectiveness and efficiency of a client’s operations in order to assess client business risk and inherent risk in the financial statements For example, if a client is experiencing inventory management problems, this would most likely increase both the auditor’s assessment of inherent risk for the planned evidence accumulation for inventory Compliance with laws and regulations – It is important for the auditor to understand the laws and regulations that affect an audit client, including significant contracts signed by the client For example, the provisions in a pension plan document would significantly affect the auditor’s assessment of inherent risk and evidence accumulation in the audit of unfunded liability for pensions If the client were in violation of the provisions of the pension plan document, inherent risk and planned evidence for pension-related accounts would increase 8-5 8-17 The purpose of a client’s performance measurement system is to measure the client’s progress toward specific objectives Performance measurement includes ratio analysis and benchmarking against key competitors Performance measurements for a chain of retail clothing stores could include gross profit by product line, sales returns as a percentage of clothing sales, and inventory turnover by product line An Internet portal’s performance measurements might include number of Web site hits or search engine speed A hotel chain’s performance measures include vacancy percentages and supply cost per rented room 8-18 Client business risk is the risk that the client will fail to achieve its objectives Sources of client business risk include any of the factors affecting the client and its environment, including competitor performance, new technology, industry conditions, and the regulatory environment The auditor’s primary concern when evaluating client business risk is the risk of material misstatements in the financial statements due to client business risk For example, if the client’s industry is experiencing a significant and unexpected downturn, client business risk increases This increase would most likely increase the risk of material misstatements in the financial statements The auditor’s assessment of the risk of material misstatements is then used to classify risks using the audit risk model to determine the appropriate extent of audit evidence 8-19 Management establishes the strategies and business processes followed by a client’s business One top management control is management’s philosophy and operating style, including management’s attitude toward the importance of internal control Other top management controls include a welldefined organizational structure, an effective board of directors, and an involved and effective audit committee If the board of directors is effective, this increases management’s ability to appropriately respond to risks An effective audit committee can help management reduce the likelihood of overly aggressive accounting 8-20 Analytical procedures are performed during the planning phase of an engagement to assist the auditor in determining the nature, extent, and timing of work to be performed Preliminary analytical procedures also help the auditor identify accounts and classes of transactions where misstatements are likely Comparisons that are useful when performing preliminary analytical procedures include:      Compare client and industry data Compare client data with similar prior period data Compare client data with client-determined expected results Compare client data with auditor-determined expected results Compare client data with expected results, using nonfinancial data 8-21 Analytical procedures are required during two phases of the audit: (1) during the planning phase to assist the auditor in determining the nature, extent, and timing of work to be performed and (2) during the completion phase, as a final review for material misstatements or financial problems Analytical procedures are also often done during the testing phase of the audit as part of the auditor’s further audit procedures, but they are not required in this phase 8-6 8-22 Gordon could improve the quality of his analytical tests by: Making internal comparisons to ratios of previous years In cases where the client has more than one branch in different industries, computing the ratios for each branch and comparing these to the industry ratios 8-23 Roger Morris performs his ratio and trend analysis at the end of every audit By that time, the audit procedures are completed If the analysis was done at an interim date, the scope of the audit could be adjusted to compensate for the findings SAS 56 (AU 329) requires that analytical procedures be performed in the planning phase of the audit and near the completion of the audit The use of ratio and trend analysis appears to give Roger Morris an insight into his client's business and affords him an opportunity to provide excellent business advice to his client 8-24 The four categories of financial ratios and examples of ratios in each category are as follows:  Short-term debt-paying ability – Cash ratio, quick ratio, and current ratio Liquidity activity – Accounts receivable turnover, days to collect receivables, inventory turnover, and days to sell inventory Ability to meet long-term debt obligations – Debt to equity and times interest earned Profitability – Earnings per share, gross profit percent, profit margin, return on assets, and return on common equity Multiple Choice Questions From CPA Examinations 8-25 a (3) b (3) c (4) 8-26 a (1) b (4) c (4) 8-27 a (4) b (1) c (2) 8-7 d (1) d (4)  Discussion Questions And Problems 8.28 Audit Activities Send an engagement letter to the client Tour the client’s plant and offices Related Planning Procedure (1) Accept client and perform initial audit planning (2) Understand the client’s business and industry Compare key ratios for the company (4) Perform preliminary analytical to industry competitors procedures Review management’s controls and (3) Assess client’s business risk procedures Identify potential related parties that (2) Understand the client’s business may require disclosure and industry Review the corporate charter and (2) Understand the client’s business bylaws and industry Identify whether any specialists are (1) Accept client and perform initial required for the engagement audit planning Review the accounting principles (2) Understand the client’s business unique to the client’s industry and industry Determine the likely users of the (1) Accept client and perform initial financial statements audit planning 8-29 a A related party transaction occurs when one party to a transaction has the ability to impose contract terms that would not have occurred if the parties had been unrelated FASB 57 concludes that related parties consist of all affiliates of an enterprise, including (1) its management and their immediate families, (2) its principal owners and their immediate families, (3) investments accounted for by the equity method, (4) beneficial employee trusts that are managed by the management of the enterprise, and (5) any party that may, or does, deal with the enterprise and has ownership, control, or significant influence over the management or operating policies of another party to the extent that an arm’s-length transaction may not be achieved When related party transactions or balances are material, the following disclosures are required: The nature of the relationship or relationships A description of the transaction for the period reported on, including amounts if any, and such other information deemed necessary to obtain an understanding of the effect on the financial statements The dollar volume of transactions and the effects of any change in the method of establishing terms from those used in the preceding period Amounts due from or to related parties, and if not otherwise apparent, the terms and manner of settlement 8-8 8-9 8-29 (continued) c d b Financial statements are used by people to make decisions about the future The presumption is that the nature of the transactions and balances in the financial statement are likely to be repeated in the future unless there is information to the contrary Related party transactions can be conducted on a basis other than that which would normally happen with independent parties That may indicate that these transactions may be on more or less favorable terms than can be expected to occur in the future These transactions may affect users’ decisions about a company, and therefore are relevant for their decision making The most important related parties that are likely to be involved in related party transactions involving management include relatives of management or management itself, companies in which such related parties have financial interests or dealings, significant suppliers of materials and services, and customers Related party transactions that could take place in a company include: e Lease of property by the company from a corporate officer who owns the property Acquisition of materials or merchandise by a company from another company which is owned or managed by an officer of the company or in which an officer of the company has a financial interest A company conducts a seminar at a facility that is owned or managed by the family or friend of an officer or another employee of the company A company contracts with a food service to run the company’s cafeteria An officer of the company has an investment in the food service Auditors can determine the existence of material transactions with related parties by performing the following procedures: Obtain background information about the client in the manner discussed in this chapter to enhance understanding of the client’s industry and business; i.e., examine corporate charter bylaws, minutes of board meetings, material contracts, etc Perform analytical procedures of the nature discussed in Chapters and to evaluate the possibility of business failure and assess areas where fraudulent financial reporting is likely Review and understand the client’s legal obligations in the manner discussed in this chapter to become familiar with the legal environment in which the client operates 8-10 8-39 (continued) A1 G2 A5 Rows for account Columns for years 07-04 Amounts headings G43 A47 Columns for years 07-04 Rows for various ratios Formulas for ratios G71 Check on accuracy of inputs A major concern is knowing that input data has been entered accurately This can usually be achieved by two alternative procedures The first is computing totals and comparing them to check figures For example, the details of assets can be computed and added to 100 The second procedure is verification of details on a figure-by-figure basis back to the source 8-28 8-39 (continued) Treatment of negative values Negative values can be entered as negative inputs or positive inputs It is important to respond properly to the treatment used when the values are included in computations Check on accuracy of formulas One of the biggest problems with using spreadsheets is errors in the development of formulas One use of each formula should be done manually to check its correctness and the formulas should receive a careful second party review If this second step is impractical, a second party should at least review the results for reasonableness Templates for the computer solutions prepared using Excel are included on the Companion Website and on the Instructor’s Resource CD-ROM, which is available upon request Solomon Bros Manufacturing Co Analytical Procedures Calculated from adjusted year-end balances KEY RATIOS Quick 2007 2006 2005 2004 96 83 81 74 21.0% 22.1% 23.2% 25.0% Average inventory turnover 1.79 1.82 1.93 NA Current 2.19 1.96 1.91 1.75 Average days to collect receivables 131.10 123.94 116.06 NA Net income/total assets 3.9% 3.9% 3.9% 4.3% Net income/sales 5.0% 5.2% 5.3% 6.1% Sales/equity 3.89:1 4.37:1 4.88:1 5.27:1 Debt/equity 4.02:1 4.82:1 5.64:1 6.42:1 19:1 23:1 26:1 32:1 10.6% 11.5% 12.5% 14.8% Bad debts/sales 3.7% 4.0% 4.1% 4.6% Sales returns and allowances/gross sales 3.1% 3.0% 3.0% 2.9% Gross margin/sales Net income/equity Allowance for doubtful accounts/accounts receivable 8-29 8-39 (continued) The Solomon brothers are considering going public to expand the business at a time that land and building costs in Boston are at extremely inflated values Presently gross profit margins are 21% of sales and net income is 5% of sales Both ratios decreased during the past year To finance expansion, additional debt is out of the question because longterm debt is presently extremely high (debt to equity ratio is 4.02) Depreciation on new plant and equipment at the inflated prices will cause high depreciation charges, which may significantly reduce the profit margins b The account that is of the greatest concern is allowance for uncollectible accounts The following are three key analytical procedures indicating a possible misstatement of allowance for uncollectible accounts: Breakdown of the aging in percent - 30 days 31 - 60 days 61 - 120 days over 120 days Allowance/accounts receivable Bad debts/sales 2007 2006 2005 2004 39.8% 33.5% 19.1% 7.6% 100.0% 42.1% 33.3% 17.6% 7.0% 100.0% 46.0% 32.0% 16.0% 6.0% 100.0% 49.9% 30.1% 15.0% 5.0% 100.0% 10.6% 3.7% 11.5% 4.0% 12.5% 4.1% 14.8% 4.6% It appears that the allowance is understated: If accounts were as collectible as before, allowance/accounts receivable should be about constant If accounts become less collectible, allowance/accounts receivable should increase Number seems to be the case The aging of accounts receivable shows a deterioration in the overall aging (0-30 decreased significantly in the past several years, while those in all other categories increased), while the allowance for uncollectible accounts as a percentage of accounts receivable has decreased from 14.8% to 10.6% This indicates that the allowance for uncollectible accounts may be understated, especially considering the trend between 2004 and 2006 Accounts Receivable The average days to collect receivables has increased steadily over the four-year period, which indicates that some accounts may not be collectible This idea is supported by the deterioration in overall aging noted above 8-30 8-39 (continued) Sales Finally, gross margin as a percentage of sales has declined steadily over the four-year period from 25% to 21% Net Income/Sales has also declined The auditor should seek an explanation from the client for these trends  Integrated Case Application 8-40 PINNACLE MANUFACTURING―PART I a Amounts (in thousands) Ratios 2007 44,497 25,926 1.72 2006 36,196 17,605 2.06 2005 36,005 16,341 2.20 Debt Equity 47,161 55,826 84.5% 37,033 52,759 70.2% 35,801 50,873 70.4% Net income b/t Sales 4,274 149,245 2.9% 3,870 137,580 2.8% 2,660 125,814 2.1% Gross margin % Gross profit Sales 44,437 149.245 29.8% 40,984 137,579 29.8% 37,129 125,814 29.5% Inventory turnover COGS Ave inventory 104,808 25,119 4.2 96,596 22,091 4.4 88,685 21,975 4.0 Current ratio: Debt to equity Net income bt/sales Current assets Current liab b There is a low risk that Pinnacle will fail financially in the next twelve months The company has been profitable the past three years, is generating significant cash flows and most of the ratios indicate no financial difficulties The current ratio and debt to equity have deteriorated somewhat, but not enough to cause significant concerns c See page 8-33 for Pinnacle’s common-size income statement For the overall financial statements, the focus is on all accounts except direct expenses For the direct expenses, it is better to use the disaggregated information The suggested solution was prepared using Excel (Filename P840.xls) 8-31 8-40 (continued) Account Balance Property taxes Estimate of $ Amount of Potential Misstatement Decrease of $140,000 when property increased Bad debts See requirement f for an analysis Depreciation expense Increase of $1.2 million, perhaps partly due to new building and equipment purchases Federal Income Taxes FIT as a % of NIBT was 36% in 2006 36% of 2004 NIBT is $1.539 million Actual FIT for 2007 was $1.014 million Difference of $525,000 Interest expense Short-term plus long-term interest bearing debt increased by 25%, from $27.3 million to $34 million, but interest expense decreased If interest rates have not changed, interest expense would be expected to increase by a similar amount to $2,661,000 ($2,129,00 x 1.25) Potential misstatement of $764,000 ($2,661,000 - $1,897,000) d See pages 8-34 to 8-36 for common-size income statement for each of Pinnacle’s three divisions The suggested solution was prepared using Excel (Filename P840.xls) For disaggregated information it is best to ignore the allocated expenses Account Balance Solar Electro: Payroll benefits Estimate of $ Amount of Potential Misstatement Increased almost $100,000 without a similar sized increase in salary and wages Payroll benefits in Welburn decreased while salary and wages increased in this division Potential misallocation between divisions Legal Service Large increase may be indicative of other issues affecting disclosures and asset or liability valuation Miscellaneous $200,000 increase needs investigation Welburn $120,000 increase in warehouse rent even though there is no evidence of any change in facilities e Both the companywide and the divisional income statements are useful, but for different purposes The companywide information is useful for identifying material fluctuations in the financial statements However, the disaggregated information is more helpful in identifying the source of the fluctuations 8-32 8-33 8-40 (continued) f Estimate of Potential Understatement in Allowance 2007 2006 2005 149,245 137,580 125,814 9,247 7,888 7,582 16.1 17.4 16.6 365 365 365 Turnover 16.1 17.4 16.6 Days 22.6 20.9 22.0 699 699 682 10,300 8,194 7,582 6.8% 8.5% 9.0% A/R Turnover Sales Average accounts receivable Turnover Days Sales Outstanding 365 Allowance as a Percentage of Gross Receivables Allowance Gross Receivables Percentage Potential understatement in allowance Suggested percent Gross accounts receivable 9.5% Estimate based on decrease in turnover 10,300 Suggested allowance 979 Actual Allowance 699 Potential understatement 280 8-34 8-40 (continued) (part of requirement c) Pinnacle Manufacturing Company Income Statement - All Divisions For the Year Ended December 31 Sales Sales Returns and Allowances Cost of Sales* Gross Profit OPERATING EXPENSES-Allocated Salaries-Management Salaries-Office Licensing and certification fees Security Insurance Medical benefits Advertising Business publications Property taxes Bad debts Depreciation expense Accounting fees Total operating expenses-Allocated OPERATING EXPENSES-Direct Salaries-Sales Wages Rental Wages-Mechanics Wages-Warehouse Garbage collection Payroll benefits Rent- Warehouse Telephone Utilities Postage Linen service Repairs and maintenance Cleaning service Legal service Fuel Travel and entertainment Pension expense Office supplies Miscellaneous Total operating expenses-Direct Total Operating Expenses Operating Income Other Expense-Interest Income Before Taxes Federal Income Taxes Net Income 2007 Dollar Value 149,424,646 2007 % of Sales 100.00% 179,470 104,807,966 44,437,210 0.12% 70.14% 29.74% 162,102 96,595,908 40,983,756 0.12% 70.13% 29.75% 2005 Dollar Value 125,982,29 168,022 88,685,361 37,128,911 2,348,025 324,392 196,229 566,716 95,924 24,415 167,268 7,194 23,246 866,330 5,492,959 281,973 10,394,671 1.57% 0.22% 0.13% 0.38% 0.06% 0.02% 0.11% 0.00% 0.02% 0.58% 3.68% 0.19% 6.96% 2,190,819 272,185 158,608 584,936 95,268 27,021 163,311 5,096 163,311 948,679 4,258,699 273,190 9,141,123 1.59% 0.20% 0.12% 0.42% 0.07% 0.02% 0.12% 0.00% 0.12% 0.69% 3.09% 0.20% 6.64% 1,995,723 266,831 141,112 548,133 94,340 25,052 144,068 673 152,776 862,690 3,797,885 260,684 8,289,967 1.58% 0.21% 0.11% 0.44% 0.07% 0.02% 0.11% 0.00% 0.12% 0.68% 3.01% 0.21% 6.56% 15,408,771 506,186 1,146,126 5,034,197 28,458 2,735,670 826,350 33,350 270,072 92,390 17,788 171,872 92,428 407,605 294,933 106,415 235,244 154,213 308,969 27,871,037 38,265,708 6,171,502 1,897,346 4,274,156 1,013,745 3,260,411 10.31% 0.34% 0.77% 3.37% 0.02% 1.83% 0.55% 0.02% 0.18% 0.06% 0.01% 0.12% 0.06% 0.27% 0.20% 0.07% 0.16% 0.10% 0.21% 18.65% 25.61% 4.13% 1.27% 2.86% 0.68% 2.18% 14,062,181 546,228 1,229,015 4,899,331 27,313 2,695,165 701,235 41,443 244,959 122,494 11,330 154,500 74,852 174,807 313,020 95,268 217,752 136,092 97,185 25,844,170 34,985,293 5,998,463 2,128,905 3,869,558 1,399,001 2,470,557 10.21% 0.40% 0.89% 3.56% 0.02% 1.96% 0.51% 0.03% 0.18% 0.09% 0.01% 0.11% 0.05% 0.13% 0.23% 0.07% 0.16% 0.10% 0.07% 18.78% 25.42% 4.33% 1.55% 2.78% 1.02% 1.76% 12,960,341 500,630 1,159,488 4,759,347 33,017 2,516,783 659,430 50,319 238,578 131,546 13,985 154,968 67,903 132,381 243,054 87,373 110,444 148,790 125,228 24,093,605 32,383,572 4,745,339 2,085,177 2,660,162 1,166,553 1,493,609 10.29% 0.40% 0.92% 3.78% 0.03% 2.00% 0.52% 0.04% 0.19% 0.10% 0.01% 0.12% 0.05% 0.11% 0.19% 0.07% 0.09% 0.12% 0.10% 19.13% 25.69% 3.78% 1.66% 2.12% 0.93% 1.19% *Details of manufacturing expense not incl 8-33 2006 Dollar Value 137,741,766 2006 % of Sales 100.00% 2005 % of Sales 100.00% 0.13% 70.40% 29.47% 8-40 (continued) (part of requirement d) Pinnacle Manufacturing Company Income Statement - Welburn Division For the Year Ended December 31 2007 $ Value Sales Sales Returns and Allowances Cost of Sales* Gross Profit OPERATING EXPENSES-Allocated Salaries-Management Salaries-Office Licensing and certification fees Security Insurance Medical benefits Advertising Business publications Property taxes Bad debts Depreciation expense Accounting fees 121,371,795 126,522 86,671,580 2007 % of Div Sales 100.00% 0.10% 71.41% 2006 2006 $ Value % of Div Sales 111,877,873 113,483 79,914,454 100.00% 0.10% 71.43% 2005 2005 $ Value % of Div Sales 102,308,887 100.00% 117,627 0.11% 73,370,003 71.71% 34,573,693 28.49% 31,849,936 28.47% 28,821,257 28.18% 1,905,965 263,320 144,046 460,017 77,861 19,956 135,777 4,336 18,396 708,015 4,329,633 230,075 1.57% 0.22% 0.12% 0.38% 0.06% 0.02% 0.11% 0.00% 0.02% 0.58% 3.57% 0.19% 1,774,466 220,457 117,118 473,767 77,159 22,048 132,276 2,735 132,276 762,910 3,449,347 220,363 1.59% 0.20% 0.10% 0.42% 0.07% 0.02% 0.12% 0.00% 0.12% 0.68% 3.08% 0.20% 1,616,447 216,121 104,199 443,958 76,407 20,441 116,690 361 123,743 693,759 3,076,109 210,276 1.58% 0.21% 0.10% 0.43% 0.07% 0.02% 0.11% 0.00% 0.12% 0.68% 3.01% 0.21% Total operating expenses-Allocated OPERATING EXPENSES-Direct Salaries-Sales Wages Rental Wages-Mechanics Wages-Warehouse Garbage collection Payroll benefits Rent- Warehouse Telephone Utilities Postage Linen service Repairs and maintenance Cleaning service Legal service Fuel Travel and entertainment Pension expense Office supplies Miscellaneous 8,297,397 6.84% 7,384,922 6.60% 6,698,511 6.54% 12,947,327 4,124,063 2,099,069 690,375 26,659 200,398 80,204 14,539 127,063 67,780 119,122 224,342 82,614 193,389 125,176 58,819 10.67% 10.41% 1.95% 0.51% 0.03% 0.18% 0.09% 0.01% 0.10% 0.05% 0.11% 0.23% 0.07% 0.16% 0.10% 0.05% 10,733,735 3,854,855 2,038,477 537,821 40,152 193,240 106,538 11,900 108,159 55,000 91,247 196,858 70,765 89,454 120,513 68,461 10.49% 1.73% 0.57% 0.02% 0.17% 0.07% 0.01% 0.10% 0.06% 0.10% 0.18% 0.07% 0.16% 0.10% 0.05% 11,646,277 3,968,235 2,182,959 571,916 33,069 198,409 99,207 9,642 107,833 60,628 120,490 253,526 77,159 176,367 110,228 53,130 Total operating expenses-Direct Total operating expenses OPERATING INCOME 21,180,939 29,478,336 5,095,357 17.46% 24.30% 4.19% 19,669,075 27,053,997 4,795,939 17.60% 24.20% 4.27% 18,317,175 25,015,686 3,805,571 17.91% 24.45% 3.73% 3.40% * Details of manufacturing expenses are not included in this schedule 8-34 3.55% 3.77% 1.99% 0.53% 0.04% 0.19% 0.10% 0.01% 0.11% 0.05% 0.09% 0.19% 0.07% 0.09% 0.12% 0.07% 8-40 (continued) (part of requirement d) Pinnacle Manufacturing Company Income Statement - Solar-Electro Division For the Year Ended December 31 2007 $ Value 22,381,936 43,430 16,311,635 100.00% 0.19% 72.88% 20,073,876 35,208 14,687,724 100.00% 0.18% 73.17% 2005 % of Div Sales 18,373,763 100.00% 36,494 0.20% 13,484,900 73.39% Gross Profit OPERATING EXPENSES-Allocated Salaries-Management Salaries-Office Licensing and certification fees Security Insurance Medical benefits Advertising Business publications Property taxes Bad debts Depreciation expense Accounting fees 6,026,871 26.93% 5,350,944 26.65% 4,852,369 26.41% 347,907 48,064 19,868 83,967 14,212 3,641 24,783 900 3,360 124,019 915,513 40,824 1.55% 0.21% 0.09% 0.38% 0.06% 0.02% 0.11% 0.00% 0.02% 0.55% 4.09% 0.18% 323,147 40,146 14,025 86,281 14,054 4,015 24,087 497 24,087 144,706 628,135 40,999 1.61% 0.20% 0.07% 0.43% 0.07% 0.02% 0.12% 0.00% 0.12% 0.72% 3.13% 0.20% Total operating expenses-Allocated OPERATING EXPENSES-Direct Salaries-Sales Wages Rental Wages-Mechanics Wages-Warehouse Garbage collection Payroll benefits Rent- Warehouse Telephone Utilities Postage Linen service Repairs and maintenance Cleaning service Legal service Fuel Travel and entertainment Pension expense Office supplies Miscellaneous 1,627,058 7.26% 1,344,179 6.69% 1,219,423 6.64% 2,256,643 716,283 492,677 107,026 4,868 54,837 7,340 2,653 35,120 21,300 276,825 55,555 18,729 35,301 22,849 241,764 10.08% 10.98% 2.20% 0.48% 0.02% 0.25% 0.03% 0.01% 0.16% 0.10% 1.24% 0.25% 0.08% 0.16% 0.10% 1.08% 2,204,049 722,659 397,542 100,370 6,025 36,131 18,069 1,367 36,131 11,039 42,156 46,171 14,054 31,182 20,073 39,433 1.98% 0.50% 0.03% 0.18% 0.09% 0.01% 0.18% 0.05% 0.21% 0.23% 0.07% 0.16% 0.10% 0.20% 2,031,351 702,011 371,231 94,386 7,315 35,190 19,404 1,688 36,241 10,014 31,925 35,851 12,889 15,815 21,946 50,811 Total operating expenses-Direct Total operating expenses OPERATING INCOME 4,349,770 5,976,828 50,043 19.44% 26.70% 0.23% 3,726,451 5,070,630 280,314 18.57% 25.26% 1.39% 3,478,068 18.94% 4,697,491 25.58% 154,878 0.83% Sales Sales Returns and Allowances Cost of Sales* 2007 % of Div Sales 3.20% * Details of manufacturing expenses are not included in this schedule 8-35 2006 $ Value 2006 % of Div Sales 3.60% 2005 $ Value 294,370 39,356 12,478 80,853 13,917 3,722 21,249 66 22,533 131,590 560,167 39,122 1.60% 0.21% 0.07% 0.44% 0.08% 0.02% 0.12% 0.00% 0.12% 0.72% 3.05% 0.21% 11.06% 3.82% 2.02% 0.51% 0.04% 0.19% 0.11% 0.01% 0.20% 0.05% 0.17% 0.20% 0.07% 0.09% 0.12% 0.28% 8-40 (continued) (part of requirement d) Pinnacle Manufacturing Company Income Statement - Machine-Tech Division For the Year Ended December 31 2007 $ Value Sales Sales Returns and Allowances Cost of Sales* Gross Profit OPERATING EXPENSES-Allocated Salaries-Management Salaries-Office Licensing and certification fees Security Insurance Medical benefits Advertising Business publications Property taxes Bad debts Depreciation expense Accounting fees Total operating expenses-Allocated OPERATING EXPENSES-Direct Salaries-Sales Wages Rental Wages-Mechanics Wages-Warehouse Garbage collection Payroll benefits Rent- Warehouse Telephone Utilities Postage Linen service Repairs and maintenance Cleaning service Legal service Fuel Travel and entertainment Pension expense Office supplies Miscellaneous Total operating expenses-Direct Total operating expenses OPERATING INCOME 2007 % of Div Sales 2006 $ Value 2006 % of Div Sales 2005 $ Value 5,299,644 13,901 1,830,458 3,455,285 5,670,915 9,518 1,824,751 3,836,646 100.00% 0.17% 32.18% 67.65% 5,790,017 13,411 1,993,730 3,782,876 100.00% 0.23% 34.43% 65.34% 94,153 13,008 32,315 22,732 3,851 818 6,708 1,958 1,490 34,296 247,813 11,074 470,216 1.66% 0.23% 0.57% 0.40% 0.07% 0.01% 0.12% 0.03% 0.03% 0.60% 4.37% 0.20% 8.29% 93,206 11,582 27,465 24,888 4,055 958 6,948 1,864 6,948 41,063 181,217 11,828 412,022 1.61% 0.20% 0.47% 0.43% 0.07% 0.02% 0.12% 0.03% 0.12% 0.71% 3.13% 0.20% 7.11% 84,906 11,354 24,435 23,322 4,016 889 6,129 246 6,500 37,341 161,609 11,286 372,033 204,801 506,186 1,146,126 193,851 28,458 143,924 28,949 1,823 14,837 4,846 596 9,689 3,348 11,658 15,036 5,072 6,554 6,188 8,386 2,340,328 2,810,544 1,026,102 3.61% 8.93% 20.21% 3.42% 0.50% 2.54% 0.51% 0.03% 0.26% 0.09% 0.01% 0.17% 0.06% 0.21% 0.27% 0.09% 0.12% 0.11% 0.15% 41.29% 49.58% 18.07% 211,855 546,228 1,229,015 208,437 27,313 114,664 28,949 2,349 10,419 5,218 321 10,536 3,185 12,161 13,323 4,055 10,203 5,791 4,622 2,448,644 2,860,666 922,210 3.66% 9.43% 21.23% 3.60% 0.47% 1.98% 0.50% 0.04% 0.18% 0.09% 0.01% 0.18% 0.06% 0.21% 0.23% 0.07% 0.18% 0.10% 0.08% 42.30% 49.41% 15.93% 195,255 500,630 1,159,488 202,481 33,017 107,075 27,223 2,852 10,148 5,604 397 10,568 2,889 9,209 10,345 3,719 5,175 6,331 5,956 2,298,362 2,670,395 784,890 * Details of manufacturing expenses are not included in this schedule 8-36 2005 % of Div Sales 100.00% 0.26% 34.54% 65.20% 1.60% 0.21% 0.46% 0.44% 0.08% 0.02% 0.12% 0.00% 0.12% 0.70% 3.05% 0.21% 7.01% 3.68% 9.45% 21.88% 3.82% 0.62% 2.02% 0.51% 0.05% 0.19% 0.11% 0.01% 0.20% 0.05% 0.17% 0.20% 0.07% 0.10% 0.12% 0.11% 43.36% 50.37% 14.83% 8-41 – ACL Problem Solution a The following is a printout of the Statistics command for Inventory Value at Cost: Field : Value Number 145 152 Total Average Positive : 694,361.94 4,788.70 Zeros : Negative : -13,882.00 2,776.40 Totals : 680,479.94 4,476.84 Abs Value: 708,243.94 Range : 110,967.60 Highest : 100,800.00 37,100.00 25,548.60 24,738.00 23,136.00 Lowest : -10,167.60 -2,774.40 -595.20 -190.72 -154.08 There are 145 positive amounts, zero amounts, and negative amounts The following is a printout of the Statistics command for Market Value: Field : MktVal Number 148 2 152 Total Average Positive : 1,030,325.21 6,961.66 Zeros : Negative : -1,263.60 -631.80 Totals : 1,029,061.61 6,770.14 Abs Value: 1,031,588.81 Range : 144,719.76 Highest : 143,880.00 47,647.00 44,098.53 42,163.20 32,970.00 Lowest : -839.76 -423.84 0.00 0.00 90.00 There are 148 positive amounts, zero amounts, and negative amounts b There are several negative values in inventory, which is not possible There is also one especially large item that should be verified c There are alternative Expressions that can be used One is Value/MktVal Three items have market value less than cost Several have a small difference between market value and cost that may night represent normal markups  8.1 Internet Problem Solution: Obtain Client Background Information Planning is one of the most demanding and important aspects of an audit A carefully planned audit increases auditor efficiency and provides greater assurance that the audit team addresses the critical issues Auditors frequently prepare audit planning documents that provide client and industry background information and discuss important accounting and auditing issues related to the client’s financial statements 8-37 8-1 (continued) Your assignment is to find and document information for inclusion in the audit planning memorandum You should obtain the necessary information by downloading a public company’s most recent annual report from its Web site (your instructor will give you the company’s name) You may also use other sources of information such as recent 10-K filings to find additional information You should address the following matters in four brief bulleted responses: • • • • Brief company history Description of the company’s business (for example, related companies and competitors) Key accounting issues identified from a review of the company’s most recent annual report (Note: Do not concentrate solely on the company’s basic financial statements Careful attention should be given to Management’s Discussion and Analysis as well as the Footnotes.) Necessary experience levels (that is, years of experience and industry experience) required of the auditors to be involved in the audit Answer: This problem allows the instructor to select any company that may be of interest The following suggested answer has been prepared based upon Target Corporation Much of the information has been taken from the company’s Web site [www.target.com] and its 10-K filing for the year ended February 1, 2003 • Brief company history - Unlike most other mass merchandisers, Target has department store roots Back in 1961, Dayton's department store identified a demand for a store that sold less expensive goods in a quick, convenient format Target was born In 1962, the first Target store opened in Roseville, Minnesota This was the first retail store to offer well-known national brands at discounted prices In the 1970s, Target paved new ground by implementing electronic cash registers storewide to monitor inventory and speed up guest service The company also began hosting an annual shopping event for seniors and people with disabilities, plus a toy safety campaign In the 1980s, Target rolled out electronic scanning nationwide Finally, in the 1990s, the company launched a number of new ventures: its first Target Greatland store, a national bridal registry - Club Wedd, and Lullaby Club Its first SuperTarget store, which combined groceries and special services with a Target Greatland store, was opened And, the company introduced its own credit card • Description of the company’s business - The company operates 1,147 Target stores in 47 states, 264 Mervyn’s and 64 Marshall Field’s stores Target Corporation employees approximately 304,000 people 8-38 8-1 (continued) The company’s retail merchandising business is conducted under highly competitive conditions in the discount, middle market and department store retail segments Its stores compete with national (e.g., Kmart, Wal-Mart, Walgreens) and local department, specialty, off-price, discount and drug store chains, independent retail stores and Internet and catalog businesses that handle similar lines of merchandise The company also competes with other companies for new store sites The company believes the principal methods of competing in its industry include brand recognition, customer service, store location, differentiated offerings, value, quality, fashion, price, advertising, depth of selection and credit availability Target is a leader in community involvement programs and believes that it is in a strong competitive position with regard to these competitive factors • Key accounting issues - The following is a list of accounting issues identified after reviewing Target’s annual report Student responses may vary  Related parties - The company is comprised of three operating segments: Target, Mervyn’s and Marshall Field’s Target contributed 84% of 2002 total revenues, while Mervyn’s and Marshall Field’s contributed 8.7% and 7.3%, respectively  LIFO inventory valuation issues - Inventory is accounted for by the retail inventory accounting method using LIFO The company’s LIFO provision decreased by $12 million from 2001 to 2002  Accounts payable - The accounts payable balance of $4.684 billion represents balances with numerous vendors and suppliers  Long-term debt and notes payable - The company has substantial long-term debt consisting of both notes payable, notes, and debentures in a total amount of $10.186 billion  Stock option plan - A stock option plan exists for key employees and non-employee members of the board of directors The plan provides for the granting of stock options, performance share awards, restricted stock awards, or a combination of awards  Pension and postretirement health care benefits - Target provides a defined benefit pension plan and certain health care benefits to employees who meet certain age, length of service and hours worked per year requirements  ESOP - The company sponsors a defined contribution employee benefit plan for employees who meet certain eligibility requirements Employees can invest as much as 80 percent of their compensation with the company matching 100 percent of he employee’s contribution up to percent of the employee’s compensation 8-39 8-1 (continued)  • Leases - The company leases a number of their retail buildings The company utilizes both operating and capital leasing arrangements The present value of operating and capital leases for the next years total $924 and $144 million, respectively Necessary experience levels - Student responses will vary, however, students should recognize that an audit team is comprised of auditors with varying levels of experience and backgrounds It is equally important that students recognize the need for auditors with industry experience (Note: Internet problems address current issues using Internet sources Because Internet sites are subject to change, Internet problems and solutions may change Current information on Internet problems is available at www.prenhall.com/arens.) 8-40 ... 70.2% 35 ,80 1 50 ,87 3 70.4% Net income b/t Sales 4,274 149,245 2.9% 3 ,87 0 137, 580 2 .8% 2,660 125 ,81 4 2.1% Gross margin % Gross profit Sales 44,437 149.245 29 .8% 40, 984 137,579 29 .8% 37,129 125 ,81 4 29.5%... 8. 7 All audit and non-audit services must be preapproved in advance by the audit committee for public companies 8. 8 The second standard of fieldwork requires the auditor to obtain an understanding... due from or to related parties, and if not otherwise apparent, the terms and manner of settlement 8- 8 8- 9 8- 29 (continued) c d b Financial statements are used by people to make decisions about